Commentary from Doug Noland’s Q1 2019 Z.1 “Flow of Funds”
The market now prices in a 21% probability of a rate cut at next week’s FOMC meeting, with an 86% probability for a cut by the July 31st meeting. I have previously addressed the unprecedented nature of commencing a Fed easing cycle with the unemployment rate at 3.6%, financial conditions loose and stocks near all-time highs. Add to this list system Credit expansion near the strongest in a decade.
It’s incredible that the Fed would reduce rates in the current backdrop, but markets are sure trying to force the Fed’s hands. That highly speculative markets have come to have such sway over the Federal Reserve (and global central banking) is indicative of the precarious nature of late-cycle market and policy dynamics.
The predicament is illuminated rather poignantly in Z.1 data. When “risk off” took hold during Q4, Non-Financial Debt growth dropped to SAAR $1.404 TN from Q3’s SAAR $2.300 TN. In short, that’s insufficient new Credit to sustain financial and economic Bubbles. Net Issuance of Debt Securities sank from Q3’s SAAR $1.808 TN to Q4’s SAAR $412 billion – with Corporate & Foreign Bonds sinking from SAAR $411 billion to SAAR negative $125 billion.
But the Fed’s January 4th dovish U-turn opened the “risk on” floodgates. Debt Securities expanded SAAR $1.783 TN in Q1, with Corporate & Foreign Bonds expanding SAAR $588 billion. Loose financial conditions powered equities higher, ensuring rapidly inflating Household Net Worth. After suffering a record $3.960 TN quarterly drop during Q4, Household Net Worth jumped a quarterly record $4.691 TN during Q1.
Financial and economic Systems have evolved to become acutely unstable. Market-based Credit so dominates system Credit expansion that “risk on”/“risk off” speculative dynamics now exert an acutely destabilizing impact on financial conditions, Credit expansion, securities prices, Household Net Worth and economic performance. In this highly speculative market environment, “risk on” ensures loose financial conditions, Credit and speculative excess, and vigorous market inflation, while exacerbating economic maladjustment.
When “risk on” invariably succumbs to “risk off,” financial conditions abruptly tighten, debt issuance tanks, system Credit growth drops sharply, markets turn illiquid, Bubbles falter, equities prices sink, Household Net Worth deflates, and the Bubble Economy commences a downward spiral. Worse yet, these dynamics are a global phenomenon.
Is the Fed really about to further feed “risk on”, stoking Bubble excess in the process? I’ll assume the Powell Fed would rather sit this one out. They are, of course, ready to respond in the event of “risk off.” But at this speculative blow-off Bubble phase, things tend to unwind really quickly. Global bonds appreciate the acute fragility and are priced for rate cuts and aggressive QE deployment.
The global yield collapse is not so much in response to economic weakness and trade war risks. The global financial system is an accident in the making. China is an accident in the making. Markets are demanding: “Give us rate cuts and prepare for aggressive QE – or we’ll give you central bankers the type of vicious market dislocation you are not prepared to contend with!” The Fed is faced with the Hobson Choice of either stoking the Bubble or waiting for incipient “risk off” – and hoping it possesses the firepower to hold things together. Markets bet confidently the Fed lacks the fortitude to wait.
Original Post: 15 June 2019